This is Yellen's gravest mistake

MichaelA. Gayed

Michael A. Gayed, CFA, winner of the 2014 Dow Award, is chief investment strategist and co-portfolio
manager at
Pension Partners, LLC., an
investment advisor which manages mutual funds and separate accounts according
to its ATAC (Accelerated Time and Capital) strategies focused on inflation
rotation. Prior to this role,
Gayed served as a portfolio manager for a large international investment group,
trading long/short investment ideas in an effort to capture excess returns. From
2004 to 2008, Gayed was a strategist at AmeriCap Advisers LLC, a registered
investment advisory firm that managed equity portfolios for large institutional
clients. In 2007, he launched his own long/short hedge fund,
using various trading strategies focused on taking advantage of stock market
anomalies. Follow him on Twitter @pensionpartners and YouTube
youtube.com/pensionpartners.

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"Success does not consist in never making mistakes but in never making the same one a second time." — George Bernard Shaw

Today’s investing environment — an outlier we’ll call post-quantitative easing part III — makes the age of moderation look like the age of turbulence.

Volatility in large-cap indices like the S&P 500
SPY, -0.87%
is nowhere to be found (so far). The VIX
VXX, +2.68%
has failed to show any kind of movement, largely because the crowd believes with gusto that SuperYellen and the League of Extraordinary Bankers got it right. Rates will likely remain low for longer than might otherwise seem necessary, and anyone who attempts to short the stock market seems to get crushed as the "everything boom" in asset markets continues.

How long this lasts is anyone's guess. However, we know from history that the nature of corrections, crashes and bear markets is very different than advances. The "staircase up/elevator down" analogy is apropos when it comes to equities, in particular, something people seem to forget. Advances tend to occur gradually, while declines tend to be swift, which makes it difficult to profitably and consistently short unless timing is nearly perfect. Yet, we all know just how important risk management is in a world full of complacency where stocks are viewed as the new money market.

But how can we know if risks are legitimately escalating in order to begin taking the right defensive measures? What would cause a prolonged period of volatility? The answer is clear: credit spreads widening. Yellen made headlines recently by arguing that it is a "grave mistake" to conduct monetary policy under a mathematical rule. Perhaps this is true, but we believe the gravest mistake of all is to conduct monetary policy and completely ignore the risks that policy is creating, specifically around the reach for yield. Risks are building because the Fed has pushed everyone into taking more risk, to the point where they have punished prudence. From a long-only sector rotation standpoint, positioning fully into Utilities
XLU, +0.02%
Consumer Staples
XLP, -0.93%
and Health Care
XLV, -1.73%
out of high-beta cyclical sectors as our equity sector rotation fund, the ATAC Beta Rotation Fund
BROTX, -0.86%
does, will matter.

Take a look below at the chart of the iShares iBoxx High Yield Bond Fund ETF
HYG, -0.12%
relative to the iShares Treasury 7-10 Year Bond ETF
IEF, +0.26%

This is one way of tracking credit risk. A rising ratio means junk debt is outperforming the "risk-free" investment of Treasuries (credit spreads narrowing) whereas a falling ratio means they are widening. Corrections in stock markets tend to occur alongside widening credit spreads as market participants punish riskier debt. Undoubtedly, credit spreads have been resilient and strong because of continued money pumping and zero interest rates. However, a severe collapse in the ratio above would likely reintroduce volatility to asset markets. This would likely cause high-beta cyclical sectors to dramatically underperform defensive low-beta ones like Utilities, Consumer Staples and Health Care.

This is where Yellen must focus her attention. On numerous occasions she has argued there is only "some" evidence of a reach for yield by market participants. There is no way with credit spreads near record lows that only "some" are investing in risk debt. This is a crowded trade and there will come a time where equities are volatile again. This likely benefits Utilities, Consumer Staples and Health Care relative to cyclical sectors, which our ATAC Beta Rotation Fund has the ability to fully position in. As a fund manager, I look forward to that happening.

What separates the men from the boys in the business of trading and investment management isn't managing return. It's managing risk. The Fed seems to have forgotten that it was its policies that led to the build-up of risks in the financial system that caused the crisis. They are making the same mistake again.

The fund currently does not invest in any of the following investments: SPY, VXX, HYG or IEF.

This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.

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